Good economic analysis requires more than static vision

‘If there’s one thing Rhode Island isn’t very good at, it’s due diligence.’

Guest Column: Leonard Lardaro

If there’s one thing Rhode Island isn’t very good at, it’s due diligence. Not because we are incapable of undertaking it and producing more-than-satisfactory analyses of various policy proposals. It’s just that we don’t. More

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OPINION

Good economic analysis requires more than static vision

‘If there’s one thing Rhode Island isn’t very good at, it’s due diligence.’

Posted:
Saturday, February 25, 2012 12:01 am

Guest Column: Leonard Lardaro

If there’s one thing Rhode Island isn’t very good at, it’s due diligence. Not because we are incapable of undertaking it and producing more-than-satisfactory analyses of various policy proposals. It’s just that we don’t.

Some years back, I found it necessary to create a term to describe how our state’s leaders deal with needed economic analysis: Due Presumption. Apparently, they continually choose to presume that whatever they think will occur will actually occur.

This is further compounded by the fact that these leaders also tend to think linearly. By this, I mean that in their minds the impact of anything is presumed to be independent of anything else. The inevitable result is the use of the word “should” far too often, and following policy changes, being surprised by the fact that things didn’t work out as had been presumed.

Worse yet, on the rare occasions when due diligence is actually undertaken, it is almost exclusively based on static analysis. Using this framework, the only effects identified are those that can be expected to occur if existing patterns and market participants remain essentially unchanged. Based on this type of analysis, increases in any type of tax always generate higher tax revenue, while tax cuts always reduce revenue.

There is no consideration of the fact that our state’s reputation as “Tax Hell Rhode Island” precedes us, or a host of other “compounding” factors, such as how changes relative to other states might mitigate possible gains, or most importantly, how market participants might change their behavior based on now-altered incentives.

The analysis of the effects of time on economic activity is called dynamic analysis. It is this type of analysis that actually attempts to account for changing behavior based on interactions with other states, altered incentives, or a host of other possible factors that can reasonably be expected to occur through time.

So, in static analysis, raising the state’s highest tax rate, as was recently proposed, it expected to generate potentially large increases in tax revenue, since it is presumed that nobody will change their behavior, nor will anyone ever leave our great state. Dynamic analysis looks at both the initial and subsequent effects of this change, incorporating the possibility that some people might actually leave our state, as hard as that might be to comprehend, and with their exit, tax revenue might peak then possibly decline in the future

So, in the first significant use of dynamic analysis here in as long as I can remember, the Rhode Island Center for Freedom & Prosperity study (“Analysis: Budget tax, fee hikes to cost jobs,” Feb. 9) concluded that the proposed changes to the sales tax made by Gov. Lincoln. D. Chafee will produce a host of what they refer to as “severe unintended consequences,” leading to their expectation that the state’s static revenue projections substantially overstate what can be expected to occur.

It is important to keep in mind, though, that as good as dynamic analysis is, it is not perfect. It too must make a number of assumptions. And some of these might have changed as the result of the Great Recession. I always prefer to base my economic assessments on dynamic analysis over static analysis.

If Rhode Island truly wants to move beyond its largely structurally based economic malaise, it needs to not only institutionalize due diligence, but base it on dynamic analysis as well. Only then will we be able to put an end to Due Presumption and investigate the actual magnitudes and interactions of the factors impacted by proposed policy changes far more accurately than has been done to date.

The benefits of this approach will accumulate very quickly – we will gain a far better understanding of key economic variables and their sensitivity to various changes.

If we fail to do this, expect many more economic “surprises” and ongoing humiliations whenever 50-state comparisons are published. •

Leonard Lardaro is a professor of economics at the University of Rhode Island, and the creator of the Current Conditions Index.

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